Question

A corporation is attempting to manage more effectively its working capital. They are looking at two possible policies:

Policy A: Current assets would be 40 percent of projected sales of $5,000,000 and current debt would be $1,500,000.

Policy B: Current assets would be 50 percent of projected sales of $5,000,000 and current debt would be $1,500,000.

Fixed assets are $4,000,000, and the firm plans to maintain a 60 percent debt-to-assets ratio. The interest rate on short-term debt is 6 percent and the interest rate on long-term debt is 9 percent. The earnings before interest and taxes are expected to be $900,000. The corporation has a tax rate of 40 percent.

a) Determine the return on equity for each alternative

b) Explain which policy is more risky

c) Recommend which policy should be chosen

Answer 1

a) ROE (under Policy A) is 15.53% while ROE (under Policy B) is 13.71%

b) Policy B is riskier than Policy A as the interest payment on Debt is larger due to the increase in debt as the ratio maintained is 60% all through.

c) Policy A should be chosen over Policy B as the return on equity is greater and the interest on the debt (both long term and short term are lower.